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Working In These Times

Friday, Dec 11, 2009, 6:09 pm

Will New Financial Reforms Be Enough to Prevent Another Meltdown?

BY Art Levine

The House passed major financial reform measures Friday that aim to tighten oversight on banks, Wall Street and financial speculators, while offering protection to the public on financial products monitored by a new Consumer Financial Protection Agency.

Financial industry lobbyists have swarmed over Washington to block financial reform, spending over $130 million earlier this year, and they've succeeded in weakening key elements of the multi-pronged legislation. That's especially been the case with the oversight of the shady trading in derivatives that helped bring down AIG and spurred a global meltdown.

Top progressive economists and financial experts gave varying grades to the new reforms in interviews with In These Times, but there's a general consensus that unless they're strengthened, the new measures won't be enough to prevent another meltdown following the collapse of another speculative bubble. Dean Baker, co-director of the Center for Economic and Policy Research, told In These Times, "There's nothing here in terms of preventing a meltdown, but it goes a little bit of the way towards protecting consumers."

The AFL-CIO and other major labor organizations have been a key part of a broad-based progressive coalition for financial reform—both to protect working families and the unions' own pension funds stock holdings. As the AFL-CIO Now blog reported Friday:

The AFL-CIO is seeking to improve the bill further as it makes its way through Congress. AFL-CIO President Richard Trumka told the Financial Services Committee in October that Congress needed to reform the Federal Reserve System to get the big banks out of Reserve Bank boardrooms before it gave the Federal Reserve any more regulatory powers.

"Trumka, who joined union members and allies at a rally outside the American Bankers Association meeting in Chicago in October, sent a clear message to bankers: 'You work for us—not the other way around.'

The biggest continuing concern: the wild-and-wooly secret trading in derviatives, those investment vehicles or bets based on underlying assets. The loopholes in regulating derivatives allow certain big manufacturers or corporations that engage in asset-based speculation in order to hedge investments  or to gamble -- like Enron did in oil futures -- to do so without regulation. Those companies, as opposed to financial firms, are deemed "end users," and there are complicated exemptions from oversight written into the new bill.

In an angry, and sometimes exaggerated rant against President Obama's coziness with Wall Street insiders, Rolling Stone's Matt Taibbi lambasted the Treasury department's proposed exemptions that made it into the legislation,  such as:

...exemptions for "end users" — i.e., almost all of the clients who buy derivatives from banks like Goldman Sachs and Morgan Stanley. Even more stunning, Frank's bill included a blanket exception to the rules for currency swaps traded on foreign exchanges — the very instruments that had triggered the Long-Term Capital Management meltdown in the late 1990s.

Given that derivatives were at the heart of the financial meltdown last year, the decision to gut derivatives reform sent some legislators howling with disgust. Sen. Maria Cantwell of Washington, who estimates that as much as 90 percent of all derivatives could remain unregulated under the new rules, went so far as to say the new laws would make things worse. "Current law with its loopholes might actually be better than these loopholes," she said.

An even bigger loophole could do far worse damage to the economy. Under the original bill, the Securities and Exchange Commission and the Commodity Futures Trading Commission were granted the power to ban any credit swaps deemed to be "detrimental to the stability of a financial market or of participants in a financial market." By the time Frank's committee was done with the bill, however, the SEC and the CFTC were left with no authority to do anything about abusive derivatives other than to send a report to Congress. The move, in effect, would leave the kind of credit-default swaps that brought down AIG largely unregulated.

University of Missouri Law Professor William Black, a former federal regulator who cracked down on the savings and loans scandals of the 80s, agrees that the bill leaves the derivatives market "dangerously wide open."

Still, as University of Maryland Law School Professor Michael Greenberger, a former federal official who sought to rein in unregulated trading in credit default swaps in the '90s, says, "The legislation has a lot of problems with it, but it's a lot better because of progressive lobbyists, after it came out of both committes [i.e., Financial Services and Agriculture]. But a lot of work still needs to be done."

The scope of the legislation was impressive, even if it didn't always meet the original regulatory goals proposed by either reformers or the White House. As the New York Times recapped:

The vote is the most significant legislative act to confront the financial crisis that exploded last year since the vast and costly bailout that was rammed through Congress at the peak of the emergency. It was an effort to address comprehensively what many of the bill’s supporters have called the underlying causes of the collapse — reckless risk-taking unrestrained by regulation.

The bill’s principal provisions establish a process for dismantling large, failing financial institutions; set up a council to identify and regulate firms that are so big, interconnected or risky that they need heightened supervision to keep them from bringing down the whole financial system; create a new consumer financial-protection agency to squelch unfair and abusive practices; and for the first time, regulate over-the-counter derivatives markets. The bill also contains provisions on executive pay, investor protection, credit ratings, hedge funds and insurance.

Despite the House action, final legislation is not imminent. The Senate is still developing its own measure for debate early next year and any Senate bill is likely to have substantial differences from the House measure, necessitating further negotiations.

There's still irresponsible, unchecked speculation on Wall Street here and overseas, while the $50 trillion annual  market in high-flying foreign currency "swaps" and overseas investments continues.

One late-inning change in the derivative legislation allowed smaller, potentially riskier alternative "exchanges" to the large-scale exchanges for deriviatives to spring up. As Mother Jones reported:

"The problem, as the Project on Government Oversight explained it, was that an amendment to the reform bill created an enormous loophole:"

Under this amendment—which was adopted by voice vote with little debate—an "alternative swap execution facility" is simply defined as anything that "facilitates" swap trades. Such a facility would not be subject to the requirements of an actual exchange, thereby avoiding the new requirements for increased transparency and accountability.... We believe that the creation of this loophole is contrary to the avowed purpose of the bill. It will inevitably lead to the same kind of trading that created the financial crisis; it will undermine the transparency requirements that are needed to protect the public from fraud and manipulation; and it is inconsistent with confining financial trading, to the greatest extent possible, to well-regulated clearing houses.

As POGO's Michael Smallberg told Mother Jones, the final version of the amendment "would define a 'swap execution facility' as simply anything or anybody that facilitates a trade, including electronic and voice brokerage facilities. This amendment would completely undermine the avowed purpose of the derivatives legislation, which seeks to move as much trading as possible to well-regulated clearing houses and exchanges."

But Professor Michael Greenberger says those "voice brokerages" in the alternative exchanges -- anyone with a phone and a desk, critics say -- must at least qualify for having sufficient capital to facilitate trades, as do those trading partners who create a deal among themselves handled by the alternative exchanges. And those alternative deals will be made public, unlike today's secret trading. He also notes that the private financial firms in the "Shadow Market" -- such as hedge funds and private equity funds -- "get caught up in the regulatory web."

Black, though, argues that the derivatives bill offers yet another exemption: "Anyone with a customized [investment] product gets no regulation," he says, as opposed to more standardized contracts which would largely get regulated. 

Yet progressive groups, including Americans for Financial Reform, have good  reason to have some pride in strengthening oversight of the financial industry. Heather Booth, the executive director of Americans for Financial Reform, declared:

Today the House of Representatives took an important step forward in protecting the wallets of all Americans from unscrupulous and abusive lending and banking practices.  The Chamber of Commerce, the big banks, and the most unscrupulous bottom feeding lenders spent hundreds of millions of dollars to try to defeat any progress, but reform is moving ahead despite them. We need to do more, but the passage of these reforms helps create a path back to jobs and economic growth, and we are appreciative of the leadership from Speaker Pelosi and Chairman Frank  in accomplishing this...

With the creation of the Consumer Financial Protection Agency, the House provided Americans with a watchdog against the tricks and traps of lenders and brokers. This is a tremendous win for consumers and for the economy as a whole. No longer will big banks be able to sell mortgages and loans that can destroy our homes, our neighborhoods, and the stability of our communities and our economy...

We are disappointed that Wall Street defeated a number of amendments that were essential to creating a system for regulating derivatives that would be effective in putting an end to the casino economy that was a fundamental source of the financial crisis. For too long these markets have operated in secrecy and the provisions in this bill do too little to change that. The legislation does make important strides in regulating private equity and hedge funds, but moving forward we must do more cover both funds AND their advisors, and to include venture capital in these new regulations.  We will work to shine daylight on the full range of the shadow markets as the bill moves to the Senate...

The Act gives the government strong resolution authority over failed large financial institutions– an essential step to prevent future TARP-style bailouts.  But the Act must be improved by placing that power in the hands of a systemic risk regulator that is fully public and accountable.

To William Black, however, even extending authority to shut down "too big to fail" institutions isn't good enough. "The horrific thing is that you can leave institutions around to fail until they're filing for bankruptcy," he says. "Why would we let systematically dangerous institutions continue, why would we constantly roll the dice?"

Still, Heather Booth, while on Bill Moyers Journal Friday night, explained the value of grassroots activism in bringing about the changes they did achieve. She was joined by George Goehl, the executive director of the National People's Alliance of advocates for low-income citizens.

In response to questions about taking on the big-spending financial industry, she said," Though it's a David and Goliath fight, we should remember that sometimes David wins." She argued passionately about the opportunities for real change organizing can bring:

Change is hard. Partly because money largely dominates politics, media, and so many factors of our life. These opposition forces, the insurance companies, the big financial interests, the big energy companies. They're still around. But this is a new moment. I actually believe that it is a historic opening. Not with a guarantee of change, but with a promise that there's an opening for change if we seize it.

Partly because there is a crisis. And people are saying, "You've got to do something about it." Partly because the old ideas don't work of saying just deregulation. Free market without really concern about real people. Or the greed is good spirit. It's partly because there is a new leadership that is turning the country. We are now moving in a new direction with big ideas around important agendas. On healthcare, on climate, on jobs, and on financial reform.

UPDATE: The PBS News Hour did a solid job of recapping what it called the "most sweeping overhaul of the financial industry since the Great Depression."

Art Levine, a contributing editor of The Washington Monthly, has written for Mother Jones, The American Prospect, The New Republic, The Atlantic, Slate.com, Salon.com and numerous other publications.

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